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The hidden risks of frontier-market investing

Commentary: Transparency, concentration, politics all at play

By

J.J.Zhang

Columnist

Emerging markets has become a well-accepted asset class for investor diversification over the last few years, representing large regional diversity with countries including China, South Korea, Brazil, Taiwan, South Africa, and others.

In contrast to developed markets, which have stagnated in growth, emerging markets have provided a source of economic growth that has proven valuable to portfolio returns.

The MSCI Emerging Market Index returned an average of 33% in the years before the financial crisis. However, those figures have become significantly weaker since then with a 2011 return of -18% and a 2012 return of 18%. In comparison, the S&P 500 returned 2% and 16% for those years.

There are many reasons why emerging markets are no longer showing the returns they used to. For countries such as China, the steep industrialization curve has passed and they are now closer to mature economies than their undeveloped status years ago. As an example, China’s most recent quarterly figures for GDP growth came in at 7%, below the 9 ½% of a few years back. Brazil also showed a 2012 GDP growth of only 0.9%, below the 3%-8% growth of the previous two years.

However, like many things, as the current generation matures, a new one grows to take its place. Though still in the early phase, the next generation of emerging market — the frontier market — has already started to develop. But what are frontier markets, how well do they perform and are they a viable asset class?

Welcome to the frontier

MSCI, a well-known market index compiler, has two frontier-market indices: the MSCI Frontier Markets and its subset, the Frontier Markets 100 Index, which focuses on the 100 largest and most liquid holdings. The Frontier Markets 100 index is available for investing via the iShares ETF FM
FM, +0.03%
.

Paul Cowan / Shutterstock.com

Qatar.

The MSCI Frontier Market 100 Index covers 20 countries. However the vast majority is focused on just five: Kuwait, Qatar, Nigeria, United Arab Emirates and Pakistan. These five make up almost 74% of the index.

Surprisingly, over 57% of the index is in financials, followed by 16% in telecommunications and 9% in energy. Consumer staples and materials only make up 8% of the sector weights, two sectors that some might consider a future growth area for soon-to-be-emerging countries.

So how well have these countries and the index performed? In 2011, Kuwait grew GDP by 8%, Qatar by 19% and Nigeria by 7%. While growth rates have slowed in 2012 and 2013, they signal significant growth potential in those countries.

Because FM only launched 8 months ago, long-term performance data is not available. Since its launch however, it has returned 17%, an impressive result compared with the iShares Emerging Market ETF
EEM, -0.22%
at 4% and the S&P 500
SPY, -0.87%
at 10% over the same time period.

An alternative option can be found at Guggenheim’s Frontier Market ETF
FRN, +0.15%
which uses the BNY Mellon New Frontier DR index and defines frontier markets “based upon an evaluation of gross domestic product growth, per-capita income growth, experienced and expected inflation rates, privatization of infrastructure and social inequalities.”

As opposed to the MSCI index, FRN has a more balanced sector exposure at 26% financials, 19% energy, 16% utilities and 11% materials. However, whereas MSCI was highly exposed to Middle Eastern countries, FRN does the same with Latin America. A staggering 80% of its regional exposure is in Latin America, followed by 11% in Africa and 6% in Asia. Looking closer at its Latin American components shows even deeper risk concentration with Chile alone representing 51% of the holdings. Safe to say, Chile will make or break this ETF.

Relatively young, FRN launched in 2008 during the height of the financial crisis and thus its historical returns are somewhat volatile. Since its launch, it has returned, before dividends, -27% compared with emerging markets at -10% and S&P 500 at 19% over the same time frame. It’s one-year performance is also lacking, down 12% compared with emerging markets at 3% and the S&P 500 at 17%. The poor performance of Latin America recently is largely to blame.

Frontier risks

Any discussion of frontier markets is incomplete without discussing risk. Many frontier markets are relatively small countries so liquidity and lack of transparency are significant issues.

In addition to the normal market risks associated with any stock investments, frontier markets also suffer from large geopolitical risk. Since many of these countries’ political and free-market institutions are still immature, investors face a range of issues such as Argentina’s default and the Arab Spring. And while developed nations are not without their own risks — Greece comes to mind — they are more stable.

From an asset-diversification perspective, the country exposure of FRN and FM brings to light a key issue: the definition of a frontier market is not fixed; it varies depending on the maker. For example Chile, which represents 51% of holdings in FRN, is defined as an emerging market by MSCI and thus does not show up at all in their frontier index.

Regional exposure is also highly uneven. FM is concentrated on the Middle East while FRN is highly concentrated in Latin America. This can lead to very different results in performance and regional diversification.

Overall, while the concept of getting in on the ground floor of a soon-to-be-emerging market is attractive, there are a lot of risks associated with it. It’s important to remember that they are soon to be emerging, they are not there yet.

In combination with the lack of long-term performance data for these markets, deciding to invest in frontier markets should be tempered with caution. If you do invest in them, the allocation should be commensurate with their size — small.

J.J.
Zhang

J.J. Zhang is chemical engineer and amateur financial adviser who was the winner in MarketWatch’s second annual World’s Next Great Investing Columnist contest. He runs the blog MarketTech Reports. You can follow him on Twitter @MarketTechRpts.

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J.J.
Zhang

J.J. Zhang is chemical engineer and amateur financial adviser who was the winner in MarketWatch’s second annual World’s Next Great Investing Columnist contest. He runs the blog MarketTech Reports. You can follow him on Twitter @MarketTechRpts.

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